BACKGROUND OF INVESTMENT
We currently have a long position in Genworth Financial ( ticker GNW ), which in October 2016 signed an agreement to be acquired by China Oceanwide for $5.43/share in cash ( see merger PR here ). In late January 2017, we posted on Seeking Alpha the following assessment regarding (1) GNW's then market valuation and (2) the likelihood of merger completion ( see here for our full article):
We estimate that Genworth's current expected value (or EV) is $4.93/share, or 49% above the closing stock price of $3.30/share on January 30, 2017. Importantly, this estimate incorporates a 25% probability that the deal does not close, due to the risks we describe herein. However, even if one were to increase this to a 50% probability of not closing, our EV for Genworth would only fall to $4.43/share, still 34% above the most recent share price.
Fast forward 11 months and one week (and a full 14 months after the deal was first announced), and, sadly for our long thesis, GNW still lacks the necessary regulatory approvals to complete the deal. Shares consequently have traded in the low $3s recently. On the plus side, however, because the stock had a significant margin of safety a year ago at $3.30 versus our assessment of expected value in the $4.43 to $4.93 range, despite all of the negative news the mark-to-market damage has thus far not been too significant (shares now trade down just 5% since our original article appeared), as shown in the stock chart below:
The main sticking point for the GNW / Oceanwide merger has been the Committee on Foreign Investment in the United States (aka CFIUS), which under the Trump Administration has been reluctant to approve acquisitions of domestic companies by Chinese acquirers. Indeed, CFIUS just blocked Moneygram's ( MGI ) acquistion by Ant Financial, leading some to conclude that the administration will block all pending Chinese acquisitions of U.S. companies (including GNW's acquisition by China Oceanwide) ( source ):
Nevertheless, GNW and China Oceanwide just provided the following status update, claiming that they still believe that CFIUS approval and closing of the China Oceanwide merger is possible ( source ):
Genworth and Oceanwide Provide Update on Efforts to Obtain CFIUS Clearance - 01/04/18 - RICHMOND, Va., Jan. 4, 2018 /PRNewswire/ -- Genworth Financial, Inc. and China Oceanwide Holdings Group Co. Ltd (Oceanwide) issued the following update on the status of their efforts to obtain clearance of their proposed transaction from CFIUS.Genworth and China Oceanwide remain committed to the transaction and have been working cooperatively with CFIUS since they first filed their original voluntary notice in January 2017. In October, the two parties withdrew their joint voluntary notice with the intent to refile the transaction with an additional mitigation approach to further protect the personal data of Genworth policyholders.
In addition, several days ago the Delaware Department of Insurance posted the following statement regarding the pending merger on its website ( source ):
Delaware Department of Insurance Updates Genworth StatusDate Posted: Tuesday, January 2nd, 2018. Dover, DE - On Tuesday, December 26, 2017, the Delaware Department of Insurance (
With respect to the reference by the Delaware regulator to "an agreement on the valuation of the remaining companies if the life insurance company is separated from the long-term care company", please note that this would (post-CFIUS sign off) likely be the key remaining regulatory issue for approval of the transaction (for more information on the Delaware and other regulatory hurdles, please see our January 2017 article).
RATINGS AGENCY DOWNGRADES
Never shy about piling on vulnerable or stressed companies, rating agencies Moody's and Fitch have added insult to GNW's recent injuries by downgrading various of its holdco and insurance subsidiary (as applicable) credit ratings over the past few months:
Fitch Downgrade (source): DECEMBER 19, 2017 / 1:57 PM: Fitch Downgrades Genworth Life Insurance Co's IFS to 'B+', Outlook Negative. (The following statement was released by the rating agency) CHICAGO, December 19 (Fitch) Fitch Ratings has downgraded the Insurer Financial Strength ((IFS)) ratings of Genworth Life Insurance Company (GLIC) and Genworth Life Insurance Company of New York (GLICNY) to 'B+' (Weak) from 'BB' (Moderately Weak) and removed them from Rating Watch Evolving. The Rating Outlook is Negative. Fitch has maintained the 'BB' (Moderately Weak) IFS ratings of Genworth Life and Annuity Insurance Company (GLAIC) on Rating Watch Evolving .... The rating actions follow a second extension of the closing deadline of a proposed acquisition of the insurers' parent, Genworth Financial Inc., by China Oceanwide Holdings Group Co. Ltd. The transaction is subject to regulatory approval and was initially expected to close by mid-2017. Regulatory review continues and the close deadline has been extended a second time, to April 2018. Fitch believes the continued delay increases the uncertainty as to whether the proposed transaction will be approved. With less certainty that the merger will be completed, the ratings of GLIC and GLICNY were downgraded to reflect ongoing concerns regarding the adequacy of their recorded LTC reserves, which is highly dependent on assumptions regarding future rate increases. GLAIC's rating remains on Rating Watch pending the completion of the acquisition by China Oceanwide . The Evolving Watch reflects uncertainty as to whether the proposed transaction will be approved. Fitch expects to resolve the Rating Watch status following regulators' approval or disapproval of the transaction . China Oceanwide plans to contribute $600 million to GNW to address the 2018 debt maturity at or before the maturity date and $525 million to Genworth Life. If consummated, Fitch believes that the transaction addresses near-term concerns regarding upcoming debt maturities and potential capital impact tied to further long-term care reserve charges. However, underperformance of the LTC business continues to pressure Genworth Life's reserve margins and capital adequacy.Moody's Downgrade (source): Rating Action: Moody's downgrades Genworth ratings; remains under review for downgrade. Global Credit Research, New York, October 03, 2017 -- Moody's Investors Service downgraded the credit ratings of Genworth Holdings, Inc. (Holdings) senior unsecured debt to B2 from Ba3, the insurance financial strength ((IFS))ratings of Genworth Life Insurance Company (GLIC) and Genworth Life Insurance Company of New York (GLICNY) to B2 from Ba3, and the IFS rating of Genworth Life and Annuity Insurance Company (GLAIC) to Ba1 from Baa2 . These actions follow the announcement by Genworth Financial (Unrated, Genworth), the ultimate parent of Genworth Holdings, on October 2, 2017 that it intends to refile its application with the Committee on Foreign Investment in the United States (CFIUS) and evaluate options to address its upcoming debt maturities in the event the transaction with China Oceanwide Holdings Group Co. Ltd. (COH; unrated) is not completed. The ratings of Genworth's US and Australian mortgage insurance ((MI))operations (Ba1 IFS rating, Positive; Baa1 IFS rating, stable, respectively) are not part of this rating action . This is due to the meaningful separation that exits between Genworth's life and mortgage insurance businesses which mitigates the weaken financial flexibility.
For reference, below are the outstanding ratings for GNW and its various insurance companies as of January 3, 2018 ( source ); importantly, Genworth Mortgage Insurance Corporation still retains its "BB+" rating, so the "Company Ratings Event" clause in the China Oceanwide merger agreement (the occurrence of which could allow China Oceanwide to terminate the transaction) has not yet been tripped:
As a reminder, the definition of "Company Ratings Event" from Article X of the merger agreement is as follows ( source ):
THE RITE AID PRECEDENT (OR WHAT NOT TO DO)
In light of the challenging environment that current faces the company, we believe that the overriding goal of those in GNW's C-suite should be to avoid (at all costs) ending up like Rite Aid ( ticker RAD ). Similar to GNW, RAD had a binding merger agreement with Walgreens ( ticker WBA ) to be acquired at $9/share in cash. Sadly for RAD shareholders, management had no real backup plan in the event the WBA merger fell through, which of course happened in June 2017 as the FTC was poised to block the deal ( see here for details). Without a viable Plan B, RAD's management had to improvise the following asset sale transaction with WBA ( source here ):
Clearly, the lesson from RAD is that the only way to succeed in negotiating is from a position of strength. Strength means having options. A viable Plan B allows one to simply walk away if Plan A proves unpalatable or infeasible (therefore a counterparty, such as WBA in RAD's case, cannot dictate the terms of a transaction). With respect to RAD, the company's massive debt burden meant that it had few attractive alternatives in the event the WBA acquisition fell apart.
GENWORTH MANAGEMENT'S RECENT P.R. MELTDOWN
In GNW's case, the market has voted with its pocketbook and the spread between the market and merger prices for GNW shares has reached an astounding 40%. Why so large? Clearly, the CFIUS roadblock under the new Presidential administration has been the major reason. In addition, though, company management (and specifically the CEO) has totally failed to communicate to the market that GNW retains adequate options in the event the China Oceanwide merger were called off--and naturally the market thus leaps to the conclusion that therefore no such options exist.
Inexplicably, at the annual shareholder meeting on December 13, 2017, GNW's CEO McInerney even went to the extent of actively talking down the company's stock price (thus presumably undermining GNW's negotiating position) in the following exchange with a shareholder ( source ):
David Robinson [shareholder] : On the liquidation value, if life and long-term care was zero, do you not see, I mean you have done the calculations, is there not a liquidation value in the $5 to $6 range that we can go ahead and move forward on rather than trying to pursue this deal with Oceanwide? I mean, can you not just liquidate the mortgage insurance businesses $3.5 billion it looks like for USMI, which is not a rich premium relative to the market today. You see what the value is in Canada and Australia and you zero out long-term care and life and can you not liquidate and get more than $5.43?Tom McInerney [CEO] : Mr. Robinson, I think that's a difficult question to answer. I would say that I think the values that you have for USMI and I think that's at the high end of the range, but in any event, there is no question that [while selling] the U.S. mortgage insurance business, the Canadian business and the Australian business would produce significant cash, almost all of that cash would be needed to pay off the debt, because to pay off the debt with that cash you would have to pay out the debt at premiums and therefore you would be left with very little cash left from selling all of those strong producing businesses . Also the Canadian and Australian businesses, the Catch 22 in selling that is today we have debt service payments of over $200 million a year and those are the two entities that pay the debt service. So, that's also a challenge, because you had by selling all of those you would eliminate all of the cash paying, dividend paying capacity of the company. And so I think the shareholders will be left with very little cash at the end of that and the life and long-term care insurance businesses which are dependent as I said on $6 billion to $8 billion, $7 billion is our current estimate of future premium increases.So, if we are able to achieve those premium increases, then perhaps the value of that businesses are zero, but if we are not able to achieve those premium increases, then the life in the LTC business probably has a negative value. And I think if you look at our stock price today, because I think the market itself is doing a similar analysis to what you are doing, Mr. Robinson. And I think what their conclusion is this is the liquidation value of the MI subsidiaries, then you pay off of [the debt] and here is [what] you are left with. And I think the share price today at $3.40 or thereabouts and that has some value in it for the fact that the deal may close at $5.43. So, I do think...that [if] this deal doesn't close, even despite the other plans which would include selling some of the businesses, you would likely end up with a price lower than where the stock price is today . So, I believe very strongly I think it's the view of the board based on the input of all of our outside advisors that $5.43 from Oceanwide still is the best deal for shareholders, because it provides a certain value or cash and eliminates the downside risk of our inability if that should occur of getting the future premium increases.David Robinson [shareholder] : The deficit of long-term care, I mean, we still don't go below zero, I mean, we are not going to owe, it can go bankrupt, but the shareholder is not going to go in rears just on that deficit. Is that not correct? I mean, can you not walk away and if you cashed out and I don't know how big a premium you are talking about on paying back to debt holders?Tom McInerney [CEO] : But again, I would say Mr. Robinson very difficult to answer that question. All of our businesses are highly regulated by state insurance departments as well as other entities. And so to the extent that there was a issue with our long-term care business and an insolvency of that business there it is unclear from a legal perspective what all the regulators who control USMI - will regulate USMI, the Australian subsidiary, the Canadian subsidiary, our life and annuity subsidiary, which is the Virginia and our New York subsidiary -what they will do. So, it's very unclear that you could just walk away from the LTC business and that insolvency that's up to courts and all of that. So again I think from a shareholders perspective to take the risk all of that is a lot more downside risk than the certainty of this deal at $5.43 per share.
We fundamentally disagree with McInerney's assertions above. On the point regarding debt prepayment premiums, for example, there is no reason why GNW would need to prepay any debt (versus simply paying off debt as it becomes due and payable). If any equity stakes in the mortgage insurance subsidiaries were monetized, GNW could simply hold the proceeds in liquid investments at the holdco level until debt maturities naturally occur (so there would not be any call premiums). Furthermore, as we detail below in our Sum-of-the-Parts Analysis for GNW, we believe that CEO McInerney is dead wrong about GNW's stock valuation absent the China Oceanwide deal completion. In fact, we arrive at a SotP valuation of $5.36/share for GNW even assuming all life/LTC operations are valued at zero (which is illogical, since at a bare minimum these deserve an equity "option value", even if that amount is de minimus).
So why would the CEO go to such lengths to knock down the idea of a Plan B for GNW and claim that the company's shares would have little value on a standalone basis? Why does he try to (in our view) scare shareholders into believing that GNW could be torpedoed by its LTC liabilities, despite the fact that the holding company has no legal obligation to support the LTC insurance subsidiary (see our further discussion on this point below)? In short, why is he so apparently illogically insistent that the China Oceanwide deal is the one and only option that will save GNW shareholders from the abyss? Probably because he's incentivized to do so. First, please see below regarding the maximum payouts the CEO and other senior management could receive in the event the merger with China Oceanwide is completed, from page 98 of the definitive merger proxy ( source ):
Second, McInerney and his key lieutenants are expected to have continuing executive roles at the company resulting from the China Oceanwide merger (note also that Oceanwide intends to expand the LTC business to the China market). The following is an excerpt from page 55 of the definitive merger proxy on this topic ( source here ):
[Prior to the signing of the merger agreement], representatives of Genworth had a telephone conference with representatives of China Oceanwide, during which representatives of Genworth and China Oceanwide discussed Genworth's policy that prohibited any discussion between Genworth executives and China Oceanwide concerning post-closing employment by China Oceanwide or the terms thereof unless expressly permitted by the Board. The representatives of China Oceanwide indicated that China Oceanwide did not have operations in the U.S. and a key component of the proposed transaction with Genworth would be to have the ability to retain its current management team and leverage their expertise in the post-closing operations of Genworth. China Oceanwide therefore wanted to have some assurances that such management team will continue with Genworth post-closing . In response, Mr. McInerney stated if China Oceanwide required further assurances in terms of post-closing commitments from employees, it should provide in the merger agreement for such arrangements to be negotiated between signing and closing, assuming the parties were able to come to terms on the definitive documents.
In effect, not only will McInerney and crew receive millions of dollars directly as a result of the closing of the transaction, they are also poised to help preside over the expanding international insurance empire which should take form post-merger (and one can only assume they will be compensated accordingly). So the Oceanwide deal is clearly a win-win scenario for Mr. McInerney and other top GNW executives, even if it is not necessarily the best option for GNW shareholders. No wonder the CEO appears (over)eager to talk down the idea of a Plan B!
GENWORTH SUM-OF-THE-PARTS ANALYSIS
GNW stock closed at $3.15/share on January 4, 2018, in comparison with net book value (ex-AOCI) of $20.10/share as of September 30, 2017, indicative of the massive amount of value trapped below the LTC operations (Genworth trades at just 16% of book value). We believe that long-term downside is limited for GNW shares, because even if one assigns a zero valuation to its life and annuity businesses (assuming the China Oceanwide merger is terminated), the sum of the parts of the remaining businesses minus the holdco net debt equals $5.36/share, as per the following calculations (share percentages for GNW Canada and GNW Australia sourced from GNW's 2016 Form 10-K , pages 11 and 13, respectively; U.S. M.I. information sourced from GNW LTM earnings releases):
Genworth Sum-of-the-Parts Valuation (ex-L&A businesses) = $2.68B, or $5.36/share based on 500 million GNW shares outstanding, 70% above the current market price, calculated as follows:
1. Value of GNW Canada equity @ 1/3/18 = 57.2% X C$3.84B X 0.80 f/x = $1.75B; plus
2. Value of GNW Australia equity @ 1/3/18 = 52.0% X A$1.47B X 0.78 f/x = $0.60B; plus
3. Value of U.S. M.I. @ 1/3/18 = 12X $298MM LTM Operating Income = $3.58B; minus
4. Estimated Net Holdco Debt @ 9/30/17 = $3.25B;
5. Equals Total of $2.68 billion.
GNW is therefore currently trading at a massive 41% discount to the SotP (ex-L&A), which seems extremely and unnecessarily pessimistic. Note that even this SotP valuation is punitively low, since GNW's life & annuity / LTC businesses would at a minimum still have option value for shareholders even in a runoff scenario (which would perhaps equal 5% of ex-AOCI book value attributable thereto, or around $0.75/share), or possibly more in a future de-stacking scenario.
Moreover, we believe that the full $5.36/share in SotP value is capable of being unlocked, since we do not believe (again, despite McInerney's prior statements) that GNW (either at the holdco level or the mortgage insurance level) has any legal obligation to inject money into, or provide other capital support to, the ailing LTC business. In this respect, we note that GNW's BLAIC capital maintenance agreement expired in October 2016, per the following excerpt from the Q3 2016 10-Q filing ( source ):
In addition, we find it highly improbable that a sophisticated and well-advised (by insurance specialist Willis Securities) party such as China Oceanwide would have agreed to acquire GNW in 2016 if there were any remaining legal obligation that GNW provide continuing support to the LTC insurance business (other than China Oceanwide's agreement at the time to inject $525 million therein). Thus we conclude that monetization of the U.S. or foreign mortgage insurance subsidiaries should be available to pay down debt maturities at the holdco level as and when needed.
GENWORTH "PLAN B" POSSIBILITIES
Referring back to the Rite Aid discussion above, in our view GNW retains plenty of viable Plan B options in order to pay down its looming $600MM Note maturity in May 2018 if the China Oceanwide deal were to fall through due to regulatory roadblocks, which maturity appears to be the main overhang on the company's share price in the near term. Note that these options are in addition to simply employing available cash already at the holdco level for debt repayment (holding company cash and liquid assets stood at approximately $830 million as of the end of Q3 2017, per GNW's Q3 2017 earnings press release ), as we assume GNW would want to maintain a permanent cash buffer at the holdco level out of prudence. Such Plan B options could include the following:
(1) Rights offering and/or China Oceanwide strategic investment in GNW equity - GNW could issue additional common equity. This could take the form of a rights offering, whereby current shareholders could subscribe for additional shares at or near the current stock price (rights offerings thus allow existing stockholders to avoid dilution in exchange for putting more capital into the business), and/or China Oceanwide could make a strategic investment in GNW equity (this could include a joint venture with GNW in China to create an LTC business there);
(2) IPO of the U.S. Mortgage Insurance business - GNW could conduct an IPO of, perhaps, 20% of the equity in its domestic mortgage insurance business. Over the past few years, peers such as Radian ( RDN ) and MGIC Investment Corp ( MTG ) have seen their share prices increase significantly along with the continued recovery of the U.S. housing sector (shares of the former have more than tripled, and shares of the latter have nearly quintupled, respectively, since the beginning of 2013). Healthy investor demand in the sector implies that GNW's U.S. M.I. stake would likely receive an attractive valuation in a public offering; and
(3) Sale of Shares of the Canadian and/or Australian Mortgage Insurance businesses - GNW could further sell down its ownership stakes in Genworth Canada ( OTCPK:GMICF ) and/or Genworth Australia. As shown in the SotP calculations above, these equity holdings are currently worth $2.35 billion, or almost 4X the amount of debt coming due in May 2018.
In addition, on a longer term basis, further options exist to unlock the value trapped in GNW's current corporate structure. One possibility would be to de-stack the company's life and LTC operations via a separate transaction involving a third party. China Oceanwide was (and, based on yesterday's press release, still is) obviously willing to inject $525 million into LTC in order to obtain the de-stacking, so clearly at such price China Oceanwide believes the benefit is worth the cost. If China Oceanwide believes this, it is reasonable to assume that another financial or strategic investor could be located to engage in a similar transaction (assuming such a transaction could obtain regulatory approval). Regulators and policyholders would be better off in the long run if a de-stacking is allowed, so long as this were to occur in connection with a capital infusion into LTC. If this is not possible, GNW could simply let these subsidiaries run off over time and shareholders would receive any residual value remaining once the claims are fully paid.
Another longer term option to consider would be the separation of GNW's U.S. M.I. business from its Life/LTC business via a spinoff of U.S. M.I. into a separately traded public company or the issuance of an M.I. tracking stock. In each case, the market would be forced to value GNW's various lines of business separately, i.e., based on the sum of the respective parts. Clearly this option would be complex (likely involving the approval of GNW's bondholders), but that does not mean it isn't doable.
The GNW / China Oceanwide saga has indeed proven to be a long and winding road since we initially wrote about it in late January 2017. While company management appears to believe that the deal can still be consummated prior to GNW's $600MM note maturity in May, serious obstacles remain. In contrast to GNW's CEO McInerney, we believe that even without the merger GNW shares are worth at least $5.36 based on a sum-of-the-parts analysis. Moreover, we see multiple avenues available for the company to deal with both near-term (debt payment) and longer term (de-stacking) challenges, which if properly implemented should unlock GNW's trapped value for shareholders. To be sure, if CFIUS and GNW's insurance regulators sign off on the China Oceanwide deal relatively expeditiously, we will accept the $5.43 merger consideration and walk away. However, GNW management must make every effort in the meantime to prepare for Plan B, as strength lies not in a myopic focus on one outcome, but rather in optionality.